I previously discussed the characteristics that make life insurance unique. Those unique characteristics allow for the development of cash value life insurance, while no other type of insurance can be so developed.
Simply put, life insurance insures a known, singular event, and that known event get closer with each passing year day. It is those unique characteristics that allow actuaries to create level premium policies, even though the risk of claim is continually increasing.
Every other type of insurance insures an event that may or may not happen, that may or may not happen more than once, and the risk of which doesn’t necessarily increase with time; the fact that you were not in a car accident this year does not mean that the odds are greater that you will be in one next year.
A basic principle of any kind of insurance is that the premium is largely determined by the odds that the insurance company will have to pay a claim during the covered period. The greater the chance the insured event will happen during the covered period, the higher the premium.
Term insurance covers and individual for a defined period. It was historically written on an annually renewable basis, i.e., the premium increased annually (since the chance that the covered event would happen increased annually), but since the 1990s, most term insurance is written with level premiums for 10, 15, 20 or even 30 years.
No matter how it is written, it is actuarially designed expire before the insured. As an example, the life expectancy of a 35 year old male is 42.08 years, according to the Commissioners 2001 Standard Ordinary Mortality Table. Life expectancy means simply that half of the people now age X will be dead by life expectancy. That means in our example, half of the 35 year old males today will die within the next 42.08 years. Some will die relatively early, but most will not. In fact, only about 16.25% won’t make it 30 years. That is based on the law of large numbers (Bernoulli’s theorem, to you math nerds).
That is what I mean when I say that term insurance is actuarially designed to expire before the insured; in the above example, 83.75% of the insured’s outlived the insurance. That doesn’t mean that term insurance is a bad deal. It certainly wasn’t to the beneficiaries of the 16.25% that died. And the 83.75% that lived had the peace of mind knowing that should they die, their beneficiaries would be provided for.
Term insurance is appropriate when the need is temporary or short term in nature, or when the need is long term, but the cash flow doesn’t exist to fund a cash value policy. However, the media (and others, to be sure) suggest that since life insurance will not be needed at some point in the future, only term insurance should be considered
Certainly, some people’s future need for life insurance will indeed be minimal or even non-existent. Just as certainly, many more will have a need until they die. To make a decision in one’s 20s or 30s that there will be no need for life insurance at some point in the future is, in my opinion, a mistake.
However, it is a (common) mistake to judge decisions based on their outcome. In our example, many (most?) people would say the term insurance was a good decision for the 16.25% who died and a poor decision for the 83.75% who lived. However, a decision about an unknown future event must be made with the information at hand, and it is either a good decision or a bad decision, regardless of the outcome. A good outcome doesn’t make a bad decision good, and a bad outcome doesn’t make a good decision bad (although admittedly, it can sometimes feel that way).
Look at it this way. Just because Mariano blew the save doesn’t make the decision to bring him in to pitch the 9th inning bad. Just because someone drives home from the bar intoxicated and suffers no adverse ramifications doesn’t mean it was a good decision.
That brings us back to our example. The mistake for that portion of the 83.75% that still need insurance after 30 years isn’t that they outlived the insurance. The mistake, if there is one, is that they misinterpreted information available to them 30 years prior.